Thus far, according to Moody’s, US financial assets have fared poorly during the fourth quarter. Fear of a fundamentally unwarranted climb by Treasury yields has weighed on the performance of earnings-sensitive securities.
The latest climb by the 10-year Treasury yield from a September 2016 average of 1.63% to a more recent 1.81% has been ascribed to expectations of a series of Fed rate hikes in response to a possibly much faster than 2% annual rate of CPI inflation. Though the current bout of inflation anxiety may be overblown, holders of earnings-sensitive securities worry about long-term borrowing costs reaching burdensome levels. In addition, higher yielding Treasury securities will drive up the returns investors demand from other assets. And, the surest way to boost an asset’s future prospective return is to lower its current price.
Since the end of September, the market value of US common stock was recently down by -4.0%. The accompanying -7.3% dive by the Russell 2000 stock price index shows that the prospective loss of liquidity to higher interest rates may weigh more heavily on small- to mid-sized companies.
For businesses incurring flat to lower sales volumes, higher borrowing costs make absolutely no sense. It should be noted that the NFIB’s survey of small businesses found that the net percent of polled firms reporting a three-month increase by sales volumes sank from the -5.5 percentage points, on average, of the year-ended June 2016 to the -7.8 points of Q3-2016. (When the net percent is negative, the number of surveyed firms incurring a decline by sales volumes tops the number reporting an increase.)
Only once during the current recovery has the sales volume statistic’s moving three-month average achieved a positive reading — the +1.1 points of the three-months-ended May 2012. For the current recovery, the sales volume index has averaged a woeful -9.4 points, which was worse than its insipid +1.0 point average of 2002-2007’s upturn.
Housing-sector share prices plunge
The fourth-quarter-to-date’s -8.0% plunge incurred by the PHLX index of housing-sector share prices reflects considerable worry over a possible ascent by benchmark yields that will stifle housing activity. Markets remember all too well how a climb by mortgage yields during the “taper tantrum” of 2013 reduced home sales.
Yes, the 10-year Treasury yield could jump up to 2% or higher, but its stay will be limited if housing buckles under the weight of higher mortgage yields. The fact that housing did not get more of a boost from a -50 bp drop by the 30-year mortgage yield from a Q3-2015 average of 3.95% to the 3.45% of Q3-2016 warns of an annual contraction by home sales if the 10-year Treasury yield remains above 2%.
Housing’s muted response to a less than 3.5% 30-year mortgage yield suggests only a limited upside for the 10-year Treasury yield. After surging by +16.1% year-over-year during the year-ended June 2016, dollar outlays on single family home construction dipped by -0.8% year-over-year during Q3-2016.
In addition, the year-over-year percent increase for unit sales of new and existing homes slowed from the 4.9% of 2016’s first half to the 1.6% of the third quarter. Looking ahead, a slowdown by the annual rise for the index of pending home sales from first-half 2016’s 1.7% to the third quarter’s 1.2% signals a slowing by home sales that risks deteriorating into an outright contraction if mortgage yields jump higher.
Inflation worries overlook deep pockets of deflation
Forecasts of a 10-year Treasury yield noticeably above 2% are derived from expectations of faster price inflation. Nevertheless, exaggerated fears of faster price inflation have surfaced at various times during the current recovery. Remember those earlier off-the-wall predictions of Weimar-like hyperinflation for the US economy? Forecasts of persistently rapid price inflation have proven to be so very wrong largely because US consumers have lacked the cash needed to fund runaway price inflation. In addition, the aging of both the US population and the US workforce add to the difficulty of sustaining accelerations by consumer prices.
Price inflation now lacks breadth. If the Fed decides to fight headline inflation, the plight of those having exposure to tangible consumer goods is likely to worsen. Third-quarter 2016’s PCE price index rose by 1.0% annually, which was well under the Fed’s 2% target for PCE price index inflation. Moreover, the third-quarter’s yearly pace for the Fed’s preferred index of consumer prices contained major pockets of consumer-goods price deflation.
For example, Q3-2016’s price index for durable consumer goods was down by -2.3% from a year earlier, while the price index for consumer nondurable goods fell by -1.3% annually. By contrast, the consumer services’ component of the PCE price index rose by 2.3% annually. Thus, consumer service price inflation explains Q3-2016’s 1.7% annual increase by the core PCE price index, which excludes food and energy prices.
Many fret over an increase by the annual rate of core CPI inflation from September 2015’S 1.9% to September 2016’s 2.2%. However, that quickening was largely the consequence of an increase by core consumer service price inflation from 2.7% to 3.2% that differed radically from an accompanying deepening of core consumer goods price deflation from -0.5% to -0.6%.The rise by the annual rate of core consumer service price inflation was driven by increases in (i) medical-care service price inflation from September 2015’s 2.4% to September 2016’s 4.8% and (ii) shelter cost price inflation from 3.2% to 3.4%. Excluding shelter costs, the annual rate of core CPI inflation rose from September 2015’s 1.0% to a still very low 1.3% for September 2016.
Shelter cost inflation may peak soon
Recent data favor a slowing of shelter cost inflation from September’s 3.4% annual pace. The National Multifamily Housing Council (NMHC) compiles an index describing the tightness of apartment market conditions for the US. The rate of change for apartment rents tends to respond with a lag of 12 to 15 months following a major swing by the index of apartment market tightness.
After most recently peaking at the 89.7 of Q1-2011, the apartment market tightness index has subsequently plunged to the 28.0 of Q3-2016. The latter was the index’s lowest reading since the 20.0 of Q2-2009, or the final quarter of the Great Recession. (Figure 1.)
Each previous drop by the apartment market conditions index to a reading of less than 30 was followed by a significantly slower rate of growth for rents and, in turn, the shelter cost component of the core CPI. For example, in response to Q2-2009’s ultra-low apartment conditions index, the average annual rate of rent inflation sank from the 3.1% of 2009’s first half to the 0.2% of April 2010 through December 2010. Thus, rent inflation is likely to slow noticeably from Q3-2016’s 3.7%.
Other forthcoming sources of consumer price disinflation include autos (owing to a glut of used vehicles and sweetened sales incentives) and restaurant meals (stemming from an excess supply of eateries).
In summary, if Treasury yields extend their latest climb absent indications of much improved profitability, the recent sell-off of high-yield bonds may continue. After bottoming at October 25’s 6.10% — the lowest reading since May 2015 — the composite speculative-grade bond yield rapidly ascended to November 2’s 6.63%. In response, the accompanying high-yield bond spread widened from 478 bp to 531 bp. The latter is very close to the spread’s predicted value of 529 bp mostly because of the return of an above-trend VIX index. To the degree Treasury yields rise faster than what is warranted by business activity, higher yields practically assure lower prices for equities and lower-grade corporates.
